The Same Patterns Remain Even When the Market Index Changes

When the Dow was careening toward 5200 not too many weeks ago, a reporter from the Wall Street Journal called and asked what I thought. I replied that the Dow had simply retraced one-third of its prior advance, which is well within the confines of a secondary correction within a bull market. As it was, the low of the day was the end of the decline and the market promptly rebounded.

Apparently, though, the reporter was not impressed with my geometry that day, so he declined to use my information. However, the Dow Theory 1/3-2/3 concept, which I explained at some length just this past January in the AAII Journal, proved out once again.

The concept also played out with other averages, such as the Nasdaq composite. While the Dow may be perceived as stodgy and the Nasdaq as the up-and-comer, both markets move in trends, and similar trend analysis is applicable.

Trend can be classified as to extent in terms of three trends: major, intermediate, and minor. We are most interested in the major trend, but it is changes in the intermediate trend that allow us to classify the major trend. This is illustrated in several charts. The major market trend is comprised of two intermediate uptrends, mid-January through late February, and then early April through early June. Figures 1 and 2 show these two intermediate trends.

The first chart, Figure 1, is the Nasdaq’s major market trend through the first half of 1996.

For demonstration purposes I am using a takeoff on the Dow Theory 1/3-2/3 concept—speed resistance lines—to represent logical support and resistance levels. Speed resistance lines [available in many technical analysis computer programs] were popularized by Edson Gould, and I am using MetaStock to calculate the lines. There are far more complex exercises done along the same concept, like Fibonacci, but I have rarely found the more complex methods to have added any value, just work.

In any case, along with basic support/resistance level analysis, which I regard as the basic building block of technical analysis, speed resistance lines can be useful in identifying expected support and resistance levels. For instance, the theory holds that, in an uptrend, prices will usually stay above the 2/3 speed resistance line during corrections; if prices do penetrate this support line, prices will tend to fall to the 1/3 speed resistance line, which becomes the new support level.

In Figure 1, the speed resistance support lines are calculated for the January-February leg. As the chart indicates, when the 2/3 line was penetrated, it suggested a further correction of the January-February advance, and the Nasdaq proceeded to fall to the 1/3 support line, which held. Note how the correction moved along up the 1/3 line before breaking out.

Figure 2 shows the speed resistance support lines for the April-June advance. The 2/3 line was penetrated, suggesting a correction of the April-June advance, but the 1/3 line was also penetrated, suggesting a correction of the entire 1996 advance.

Figure 3 affords another perspective that can be seen by an analysis of the entire 1996 advance. Look at how the March-April correction skipped along the 2/3 line. However, in June, the Nasdaq moved below the 2/3 line, which had been support and now became resistance. After a rally to that resistance level, down went the Nasdaq.

Figure 4 is an analysis of the long-term November 1994-June 1996 advance. Note how the Nasdaq held support at the 2/3 line in December 1995. In June 1996, the 2/3 line failed, suggesting that the Nasdaq would move toward the 1/3 line. Note how the rally in late July and early August is moving back up to slightly above the 2/3 line, which now should act as resistance.

The implications are for either a sideways move to meet an uptrending support line, or a steep decline to meet it sooner. Since important support lies at 1000, I would opt for the Nasdaq moving more or less sideways until the rising 1/3 line is encountered. Nonetheless, if 1000 fails to hold, there will be some serious selling ahead.

In any case, the breaking of various support lines has already had bearish implications. The interaction of the Nasdaq with its primary resistance level, now at 1150, and support at 1000, will set the tone for that market.

Speed resistance lines, of course, work on the upside as well, with the upside breakthrough of the speed resistance lines offering bullish interpretations. Note that Figure 5 uses intraday lows and Figure 6 uses closing lows—offering two different implications. Closing lows, however, are the more significant numbers.

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Speed resistance lines are just a tool to use with basic support/resistance theory, which clearly shows resistance at 1150 and support close to 1000.

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